Obstacles to an XM, Sirius Merger

To go beyond talk of joining forces, the rival satellite radio services must get in tune with regulators, shareholders, and their own executives

When they first launched at the International Consumer Electronics Show in Las Vegas in 2001, the two major satellite service companies XM Satellite Radio and Sirius Satellite Radio were bitter rivals.

So bitter, in fact, that executives from both companies took every chance they could to smack each other down in public. In press conferences and statements, they'd decline to refer to each other by name. And though their spaces on the trade-show floor were near each other, the walls of each were positioned so that you couldn't see one when standing in the space of the other.

Half a decade later, officials from XM and Sirius are talking about each other a lot—and now it's in reference to a possible merger. Public statements by Sirius (SIRI) Chief Executive Mel Karmazin, its Chief Financial Officer David Frear, and XM (XMSR) Chairman Gary Parsons indicate the companies are circling each other, wondering if it would be worthwhile to bury the hatchet.

Satellite Slowdown

The public chatter gives rise to a host of questions that will have to be worked out when and if the two sides consummate a deal. For starters, would a merger make financial sense, how would it be structured, and will regulators concerned about the formation of a monopoly let a deal go through? And importantly, will larger-than-life executive personalities get in the way?

Sirius' Karmazin fired the start gun on a round of merger speculation in June when he expressed interest in buying XM at a fair price. And judging from the slump in XM's stock, the price is getting fairer all the time. The shares closed at $14.81 on Dec. 7, giving XM a market value of less than $4 billion, or about half of what it was at this time a year ago. Slowing sales growth and losses that have widened each year of its existence have hammered the stock, making it one of the worst performers on the NASDAQ stock market this year.

The picture at Sirius isn't much better. Sirius stock closed at $3.88 on Dec. 7, up 5 cents, or more than 1%, on the merger talk. It had taken a beating two days earlier on news that the company wouldn't add as many subscribers as expected this year (see, 12/5/06, "Sirius Sings the Holiday Blues"). The company said it would finish 2006 with 5.9 million to 6.1 million customers, vs. a previously forecast 6.3 million.

Numbers Favor a Deal

Not everyone's convinced the companies should or will get together. "It's all hype sparked by lowered guidance from Sirius," says Chad Bartley of Pacific Crest Securities in Portland, Ore. "I think that to talk about a merger at this point in the satellite radio growth curve is premature."

Still, others say a merger may happen in 2007. Companies led by Karmazin have made more than 20 major acquisitions worth a combined $80 billion, wrote Kit Spring, analyst with Stifel Nicolaus in Denver, in a research report issued Nov. 27. A successful merger would create as much as $7 billion in shareholder value and carries a risk of destroying only $1 billion, he notes. "Unlike most media mergers, we calculate revenue and dramatic expense synergies in a merger—around 50% of the combined market enterprise values," he wrote.

The potential for cost savings is clear. Customer-acquisition costs at Sirius amounted to $183 a head in its most recent quarter, vs. $60 a head at XM. Combining the marketing and sales operations would likely cut costs at both. And the companies' combined heft would help them negotiate better terms on manufacturing, purchases, and partnerships with auto companies eager to install satellite radio devices in cars.

"Financially, it absolutely makes sense," says Banc of America Securities analyst Jonathan Jacoby.

Antitrust Approval?

XM Chairman Parsons, asked about the potential of a merger during an appearance on CNBC on Dec. 7, declined to address the speculation directly, saying he'd leave it to the media. But he also said that no direct talks about such a deal are under way. Earlier he had said during a conference in New York that antitrust regulators would have few reasons to object should the two companies merge.

They wouldn't? It depends on how you define the market for XM and Sirius, says Spring of Stifel Nicolaus. "Whether or not the merger would be approved depends on if satellite radio is defined as part of a market that includes or excludes terrestrial radio, and to a far lesser extent iPods and MP3 players and Internet radio," he says.

Indeed, Sirius and XM both transmit programming via satellite, but both have extended their abilities to offer programming over the Internet via PC-based streaming services and, in the case of Sirius, music streamed via wireless phone on Sprint's (S) network. And both services offer handheld portable players that have the ability to record satellite programming and play MP3s, much like Apple's (AAPL) iPod player and Microsoft's (MSFT) Zune.

And that's a key question. Satellite TV giants Dish Networks (DISH) and DirecTV (DTV) weren't allowed to merge in 2001 because of regulatory objections. If they couldn't do it, the thinking goes, XM and Sirius won't get a green light either. Doing the pre-merger dance in public is a good way to take the temperature of official Washington, where both the Justice Dept. and the Federal Communications Commission will have a say on the issue.

Wild Card: Executive Egos

Of course, a deal will ultimately depend on whether Karmazin and Parsons can work together. "The question is who is going to be running the combined entity," says Jacoby at Banc of America Securities. "There are huge egos involved, and that's the main reason it may not happen."

Those egos will have to reach agreement on how to structure a deal that would likely involve a share swap. Now, Sirius shares are trading at a premium to XM's and it's in the interest of Sirius stockholders for XM to increase in value, says Sanford Bernstein analyst Craig Moffett. That puts Karmazin in the unusual position of wanting to talk up the value of XM—odd, given the historical enmity between the two. "If you start with the premise that Mel wants to get a deal done, the hard part will be coming up with an exchange ratio," says Moffett. "If they tried to do a deal now, the premium would be too high for it to sit well with Sirius shareholders, so I think Mel may be trying to use the market to do some of the heavy lifting for him."

And what of Parsons at XM? "He's in no rush to do a deal because he knows that the fundamentals at Sirius are about to get worse, as Sirius hits some of the potholes that XM hit a few years ago," says Jacoby. "Parsons thinks he's going to be the one to buy."

However it's constructed, is a deal likely? Odds are the two sides will at least give it a shot—and maybe the bitterest of enemies will turn out to be friends.

Click here for a slide show of XM and Sirius' stars.

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